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Jun 26, 2014

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Cost

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2 Aufrufe

Cost

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

- Principles: Life and Work
- The Intelligent Investor, Rev. Ed
- The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness
- Business Adventures: Twelve Classic Tales from the World of Wall Street
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- MONEY Master the Game: 7 Simple Steps to Financial Freedom
- The Law of Sacrifice: Lesson 18 from The 21 Irrefutable Laws of Leadership
- Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth
- I Will Teach You to Be Rich, Second Edition: No Guilt. No Excuses. No BS. Just a 6-Week Program That Works
- Secrets of Six-Figure Women: Surprising Strategies to Up Your Earnings and Change Your Life
- Bad Blood: Secrets and Lies in a Silicon Valley Startup
- The Total Money Makeover: A Proven Plan for Financial Fitness
- The Intelligent Investor Rev Ed.
- You Are a Badass at Making Money: Master the Mindset of Wealth
- The Intelligent Investor

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O U T L I N E

1. Introduction

2. Determining the proportion of each capital component

3. Determining the cost of each capital component

4. Assembling the pieces: The cost of capital

5. Summary

1. Introduction

The cost of capital is the company's cost of using funds provided by creditors and shareholders. A

company's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and

common equity. And the cost of each source reflects the risk of the assets the company invests in. A

company that invests in assets having little risk in producing income will be able to bear lower costs

of capital than a company that invests in assets having a higher risk of producing income. For

example, a discount retail store has much less risk than an oil drilling company. Moreover, the cost of

each source of funds reflects the hierarchy of the risk associated with its seniority over the other

sources. For a given company, the cost of funds raised through debt is less than the cost of funds

from preferred stock that, in turn, is less than the cost of funds from common stock. Why? Because

creditors have a senior claim over assets and income relative to preferred shareholders, who have

seniority over common shareholders.

If there are difficulties in meeting obligations, the creditors receive their promised interest and

principal before the preferred

shareholders who, in turn,

receive their promised

dividends before the common

shareholders. If the company is

liquidated, the funds from the

sale of its assets are distributed

first to debt-holders, then to

preferred shareholders, and

then to common shareholders

(if any funds are left). An

example of the possibility of

insufficient funds to pay

claimants is the case of Eastern

airlines, which declared

bankruptcy in 1991, is shown in

Exhibit 1.

Exhibit 1 Case in point: The satisfaction of claims in the

Eastern Airlines bankruptcy and liquidation

I n millions

Claim type

Claim

amount Payout

Secured debt with sufficient collateral $747.1 $747.1

Secured debt with insufficient collateral $453.7 $234.2

Accrued interest on secured debt $308.2 $174.4

Unsecured debt $1,575.0 $175.8

Preferred stock 350.8 $0.0

Common stock $820.0 $0.0

Source: Lawrence A. Weiss and Karen H. Wruck, Information problems, conflicts

of interest, and asset stripping: Chapter 11s failure in the case of Eastern

Airlines, J ournal of Financial Economics, Vol. 48, 1998, p 86.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 1

Eastern Airlines secured creditors had collateral (i.e., security) that was sufficient to pay their claims;

all other claimants did not receive their full claim on the assets of the company because there simply

were insufficient funds available at the time the company liquidated.

For a given company, debt is less risky than preferred stock, which is less risky than common stock.

Therefore, preferred shareholders require a greater return than the creditors and common

shareholders require a greater return than preferred shareholders.

Figuring out the cost of capital requires us to first determine the cost of each source of capital we

expect the company to use, along with the relative amounts of each source of capital we expect the

company to raise. Then we can determine the marginal cost of raising additional capital. We can do

this in three steps:

Step 1: Determine the proportions of each source to be raised as capital.

Step 2: Determine the marginal cost of each source.

Step 3: Calculate the weighted average cost of capital.

We look at each step in this reading. We first discuss how to determine the proportion of each source

of capital to be used in our calculations. Then we calculate the cost of each source. The proportions

of each source must be determined before calculating the cost of each source since the proportions

may affect the costs of the sources of capital. We then put together the cost and proportions of each

source to calculate the company's marginal cost of capital. We also demonstrate the calculations of

the marginal cost of capital for an actual company, showing just how much judgment and how many

assumptions go into calculating the cost of capital. That is, we show that it's an estimate.

The cost of capital for a company is the cost of raising an additional dollar of capital. Suppose that a

company raises capital in the following proportions: debt 40 percent, preferred stock 10 percent, and

common stock 50 percent. This means an additional dollar of capital is comprised of 40 of debt, 10

of preferred stock, and 50 of common stock.

Our goal as financial managers is to estimate the optimum proportions for our company to issue new

capital -- not just in the next period, but well beyond. If we assume that the company maintains the

same capital structure -- the mix of debt, preferred stock, and common stock -- throughout time, our

task is simple. We just figure out the proportions of capital the company has at present. If we look at

the company's balance sheet, we can calculate the book value of its debt, its preferred stock, and its

common stock. With these three book values, we can calculate the proportion of debt, preferred

stock, and common stock that the company has presently. We could even look at these proportions

over time to get a better idea of the typical mix of debt, preferred stock and common stock.

But are book values going to tell us what we want to know? Probably not. What we are trying to

determine is the mix of capital that the company considers appropriate. It is reasonable to assume

that the financial manager recognizes that the book values of capital are historical measures and

looks instead at the market values of capital. Therefore, we must obtain the market value of debt,

preferred stock, and common stock.

If the securities represented in a company's capital are publicly traded -- that is, listed on exchanges

or traded in the over-the-counter market -- we can obtain market values. If some capital is privately

placed, such as an entire debt issue that was bought by an insurance company or not actively traded,

our job is tougher but not impossible. For example, if we know the interest, maturity value, and

maturity of a bond that is not traded and the yield on similar risk bonds, we can get a rough estimate

of the market value of that bond even though it is not traded.

Once we determine the market value of debt, preferred stock, and common stock, we calculate the

sum of the market values of each, and then figure out what proportion of this sum each source of

capital represents. But the mix of debt, preferred stock, and common stock that a company has now

may not be the mix it intends to use in the future. So while we may use the present capital structure

The Cost of Capital, a reading prepared by Pamela Peterson Drake 2

as an approximation of the future, we really are interested in the company's analysis and resulting

decision regarding its capital structure in the future.

2. Determining the cost of each capital component

A. The cost of debt

The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you

borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the lender for

the use of her money. Since Congress allows you to deduct from you income the interest you paid,

how much does this dollar of debt really cost you? It depends on your marginal tax rate -- the tax

rate on your next dollar of taxable income. Why the marginal tax rate? Because we are interested in

seeing how the interest deduction changes your tax bill. We compare taxes with and without the

interest deduction to demonstrate this.

Suppose that before considering interest expense you have $2 of taxable income subject to a tax rate

of 40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your taxable

income by $0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40 percent =

$0.76. By deducting the $0.10 interest expense, you have reduced your tax bill by $0.04. You pay out

the $0.10 and get a benefit of $0.04. In effect, the cost of your debt is not $0.10, but $0.06 -- $0.04

is the government's subsidy of your debt financing. We can generalize this benefit from the tax

deductibility of interest. Let rd represent the cost of debt per year before considering the tax

deductibility of interest, r

*

d

represent the cost of debt after considering tax deductibility of interest,

and t be the marginal tax rate. The effective cost of debt for a year is:

r

d

*

= r

d

(1 - t)

Using our example, r

d

=

$0.10

$1.00

= 10 percent and t = 40 percent and the effective cost of debt is:

r

d

*

= 0.10 (1 - 0.40) = 0.06 or 6 percent per year.

Creditors receive 10 percent, but it only costs the

company 6 percent.

Example 1: The cost of debt

In our example, the required rate of return is easy to

figure out: we borrow $1, repay $1.10, so your

lender's required rate of return of 10 percent per

year. But your cost of debt capital is 6 percent per

year, less than the required rate of return, thanks to

Congress. Most debt financing is not as straight-

forward, requiring us to figure out the yield on the debt -- the lender's required rate of return -- given

information about interest payments and maturity value.

Problem

Suppose the Plum Computer Company can issue

debt with a yield of 6 percent. If Plum's marginal

tax rate is 40 percent, what is its cost of debt?

Solution

r

d

= 0.06 (1 0.40) =0.0360 or 3.6 percent

The Cost of Capital, a reading prepared by Pamela Peterson Drake 3

Example 2: Cost of debt

Problem

Suppose the ABC Company can issue bonds with a face value of $1,000, a coupon rate of 5 percent (paid semi-

annually), and 10 years to maturity at $980 per bond. If the ABC Companys marginal tax rate is 30 percent,

what is its cost of debt?

Solution

Given: FV = $1,000; PV = $980; N = 20; PMT = $25

r

d

= 2.6299% x 2 = 5.2598%

r

d

*

= 5.2598% (1 - 0.30) = 3.6819%

B. The cost of preferred equity

The cost of preferred equity is the cost associated with raising one more dollar of capital by

issuing shares of preferred stock. Preferred stock is a perpetual security -- it never matures. Consider

the typical preferred stock with a fixed dividend rate, where the dividend is expressed as a

percentage of the par value of a share.

The value of preferred equity is the present value of all future dividends to be received by the

investor. If a share of preferred stock has a 5 percent dividend (based on a $100 par value) paid at

the end of each year, the value of the stock today is the present value of the stream of $5's forever:

Value of preferred equity = P = $5 / cost of preferred stock

If the cost of preferred equity is 10 percent, the price a share of stock is worth $5/0.10 = $50.

Therefore,

Cost of preferred equity = r

p

=

Dividend

Price per share

Because dividends paid on preferred stock are not

deductible as an expense for the issuer's tax

purposes, the cost of preferred stock is not adjusted

for taxes -- dividends paid on this stock are paid out

of after-tax dollars.

Example 3: The cost of preferred equity

Problem

Suppose the XYZ Company is advised that if it

issues preferred stock with a fixed dividend of

$4 a share, it will be able to sell these shares

at $50 per share. What is the cost of

preferred stock to XYZ?

C. The cost of common equity

The cost of common equity is the cost of raising

one more dollar of common equity capital, either

internally -- from earnings retained in the company -

- or externally -- by issuing new shares of common

stock. There are costs associated with both

internally and externally generated capital.

Solution

r

p

= $4/$50 = 8%

How does internally generated capital have a cost? As a company generates funds, some portion is

used to pay off creditors and preferred shareholders. The remaining funds are owned by the common

shareholders. The company may either retain these funds (investing in assets) or pay them out to

the shareholders in the form of cash dividends. Shareholders will require their company to use

The Cost of Capital, a reading prepared by Pamela Peterson Drake 4

retained earnings to generate a return that is at least as large as the return they could have

generated for themselves if they had received as dividends the amount of funds represented in the

retained earnings.

Retained funds are not a free source of capital. There is a cost. The cost of internal equity funds (i.e.,

retained earnings) is the opportunity cost of funds of the company's shareholders. This opportunity

cost is what shareholders could earn on these funds for the same level of risk. The only difference

between the costs of internally and externally generated funds is the cost of issuing new common

stock. The cost of internally generated funds is the opportunity cost of those funds -- what

shareholders could have earned on these funds. But the cost of externally generated funds (that is,

funds from selling new shares of stock) includes both the sum of the opportunity cost and cost of

issuing the new stock.

The cost of issuing common stock is difficult to estimate because of the nature of the cash flow

streams to common shareholders. Common shareholders receive their return (on their investment in

the stock) in the form of dividends and the change in the price of the shares they own. The dividend

stream is not fixed, as in the case of preferred stock. How often and how much is paid as dividends is

at the discretion of the board of directors. Therefore, this stream is unknown so it is difficult to

determine its value.

The change in the price of shares is also difficult to estimate; the price of the stock at any future

point in time is influenced by investors' expectations of cash flows farther into the future beyond that

point. Nevertheless, there are two methods commonly used to estimate the cost of common stock:

the dividend valuation model and the capital asset pricing model. Each method relies on

different assumptions regarding the cost of equity; each produces different estimates of the cost of

common equity.

Cost of common equity using the dividend valuation model

The dividend valuation model (DVM) states that the price of a share of stock is the present value

of all its future cash dividends, where the future dividends are discounted at the required rate of

return on equity, r. If these dividends are constant forever (similar to the dividends of preferred

stock, we just covered), the cost of common stock is derived from the value of a perpetuity.

However, common stock dividends do not usually remain constant. It's typical for dividends to grow

at a constant rate. Using the dividend valuation model,

P = D

1

(r

e

- g)

where D

1

is next period's dividends, g is the growth rate of dividends per year, and P is the current

stock price per share. Rearranging this equation to solve instead for r

e

,

r

e

= ( D

1

/ P ) + g

we see that the cost of common equity is the sum of next period's dividend yield, D

1

/P, plus the

growth rate of dividends:

Cost of common equity = Dividend yield + Growth rate of dividends

Consider a company expected to pay a constant dividend of $2 per share per year, forever. If the

company issues stock at $20 a share, the company's cost of common stock is:

r

e

= $2/$20 = 0.10 or 10 percent per year.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 5

But, if dividends are expected to be $2 in the next period and grow at a rate of 3 percent per year,

and the required rate of return is 10 percent per year, the expected price per share (with D

1

= $2

and g = 3 percent) is:

P = $20 / (0.10 - 0.03) = $28.57.

The DVM makes some sense regarding the relation between the cost of equity and the dividend

payments: The greater the current dividend yield, the greater the cost of equity and the greater the

growth in dividends, the greater the cost of equity. However, the DVM has some drawbacks:

How do you deal with dividends that do not grow at a constant rate? This model does not

accommodate non-constant growth easily.

What if the company does not pay dividends now? In that case, D1 would be zero and the

expected price would be zero. But a zero price for stock does not make any sense! And if

dividends are expected in the future, but there are no current dividends, what do you do?

What if the growth rate of dividends is greater than the required rate of return? This implies

a negative stock price, which isn't possible.

What if the stock price is not readily available, say in the case of a privately-held company?

This would require an estimate of the share price.

Therefore, the DVM may be appropriate to use to determine the cost of equity for companies with

stable dividend policies, but it may not applicable for all companies.

Example 4: The cost of equity using the DVM

Cost of common equity using the

capital asset pricing model

The investor's required rate of return is

compensation for both the time value of

money and risk. To figure out how much

compensation there should be for risk,

we first have to understand what risk we

are talking about. The capital asset

pricing model (CAPM) assumes an

investor holds a diversified portfolio -- a

collection of investments whose returns

are not in synch with one another. The

returns on the assets in a diversified

portfolio do not move in the same direction at the same time by the same amount. The result is that

the only risk left in the portfolio is the risk related to movements in the market as a whole (i.e.,

market risk).

If investors hold diversified portfolios, the only risk they have is market risk. Investors are risk

averse, meaning they don't like risk, so if they are going to take on risk they want to be

compensated for it. Investors who only bear market risk need only be compensated for market risk.

If we assume all shareholders' hold diversified portfolios, the risk that is relevant in the valuing a

particular investment is the market risk of that investment. It is this market risk that determines the

investment's price. The greater the market risk, the greater the compensation -- meaning a higher

yield -- for bearing this risk. And the greater the yield, the lower the present value of the asset

because expected future cash flows are discounted at a higher rate that reflects the higher risk.

The cost of common equity, estimated using the CAPM, is the sum of the investor's compensation for

the time value of money and the investor's compensation for the market risk of the stock:

Problem

Consider the Plum Computer Company that currently

pays an annual dividend of $2.00 per share. Plum's

common stock has a current market value of $25 per

share. If Plum's annual dividends are expected to grow

at 5 percent per year, what is its cost of common stock?

Solution

Given: P = $25; D

0

= $2.00; g = 5%

D

1

= D

0

(1 + g) = $2.00 (1 + 0.05) = $2.10

r

e

= ( D

1

/P ) + g = 0.084 + 0.05 = 0.134 or 13.4%

The Cost of Capital, a reading prepared by Pamela Peterson Drake 6

Compensation for the Compensation for

Cost of common equity =

time value of money market risk

+

Let's represent the compensation for the time value of money as the expected risk-free rate of

interest, r

f

. If a particular common stock has market risk that is the same as the risk of the market as

a whole, then the compensation for that stock's market risk is the market risk premium. The market's

risk premium is the difference between the expected return on the market, r

m

, and the expected risk-

free rate, r

f

:

r

e

= r

f

+ (r

m

- r

f

)

where r

f

is the expected risk free rate of interest, is a measure of the company's stock return to

changes in the market's return (beta), and r

m

is the expected return on the market.

The CAPM is based on two ideas that

make sense: investors are risk averse

and they hold diversified portfolios. But

the CAPM is not without its drawbacks.

First, the estimates rely heavily on

historical values -- returns on the stock

and returns on the market. These

historical values may not be

representative of the future, which is

what we are trying to gauge. Also, the

sensitivity of a company's stock returns

may change over time; for example,

when the company changes its capital

structure. Second, if the company's stock

is not publicly-traded, there is no source for even historical values.

Example 5: The cost of equity using the CAPM

Problem

The Plum Computer Company's common stock has an

estimated beta of 1.5. If the expected riskfree rate of

interest is 3 percent and the expected return on the

market is 9 percent, what is the cost of common stock

for Plum Computer Company?

Solution

Given: r

f

= 3%; r

m

= 9%; = 1.5

r

e

= r

f

+ (r

m

r

f

)

r

e

= 3% + 1.5 (9% 3%) = 12%

3. Assembling the pieces: The cost of capital

The cost of capital is the average of the cost of each source, weighted by its proportion of the total

capital it represents. Hence, it is also referred to as the weighted average cost of capital

(WACC) or the weighted cost of capital (WCC). The weighted average cost of capital is:

WACC = w

d

r

d

*

+ w

p

r

p

+ w

e

r

e

where

w

d

is the proportion of debt in the capital structure;

w

p

is the proportion of preferred stock in the capital structure; and

w

e

is the proportion of common stock in the capital structure.

As you raise more and more money, the cost of each additional dollar of new capital may increase.

This may be due to a couple of factors: the flotation costs and the demand for the security

representing the capital to be raised.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 7

As you raise more and more money, the cost

of each additional dollar of new capital may

increase. This may be due to a couple of

factors: the flotation costs and the demand

for the security representing the capital to be

raised. For example, the cost of internal funds

from retained earnings will differ from the

cost of funds from issuing common stock due

to flotation costs. If a company expects to

generate $1,000,000 entirely from what's

available in internal funds -- retained earnings

-- there are no flotation costs. But if the

company needs $1,000,001, that $1 above

$1,000,000 will have to be raised externally,

requiring flotation costs.

Example 6: Calculating the WACC

Problem

Consider the Plum Computer Company once again.

Suppose Plum will raise capital in the following

proportions: Debt: 40 percent; Preferred stock: 10

percent; Common stock: 50 percent. What is Plum's

weighted average cost of capital if its cost of debt is 3.6

percent, its cost of preferred stock is 8 percent, and its

cost of common stock is 12 percent?

Solution

WACC = 0.40 (0.036) + 0.10 (0.08) + 0.50 (0.12)

WACC = 0.0144 + 0.008 + 0.06

WACC = 0.0824 or 8.24%

Additional capital may be more costly since

the company must offer higher yields to entice investors to purchase ever larger issues of securities.

Considering the effects of flotation costs and the additional yield necessary to entice investors, we

most likely face a schedule of marginal costs of debt capital and a schedule of marginal costs of

equity capital. Hence, we need to determine at what level of raising funds the marginal cost of capital

for the company changes.

Exhibit 2 Return on capital v. cost of capital

Let's see what maximizing shareholder

wealth means in terms of making

investment and financing decisions.

To maximize owners wealth we must

invest in a project until the marginal

cost of capital is equal to its marginal

benefit. What is the benefit from an

investment? It is the internal rate of

return -- also known as the marginal

efficiency of capital. If we begin by

investing in the best projects (those

with highest returns), and then

proceed by investing in the next best

projects, and so on, the marginal

benefit from investing in more and

more projects declines.

Also, as we keep on raising funds and

investing them, the marginal cost of funds increases. To maximize shareholders' wealth, we should

invest in projects to the point where the increasing marginal cost of funds is equal to the marginal

benefit from our investment. Relation between the marginal cost of capital (MCC) and the marginal

return on investment (IRR) is shown in Exhibit 2. The point at which the marginal cost and marginal

benefit intersect is the optimal capital budget. This is the point at which the value of the company is

maximized.

0%

5%

10%

15%

20%

25%

$10 $20 $30 $40 $50 $60

Additional capital

Return or

cost of

capital

IRR MCC

4. Getting real with the marginal cost of capital

Determining the cost of capital appears straight-forward: find the cost of each source of capital and

weight it by the proportion it will represent in the company's new capital. But it is not so simple.

There are many problems in determining the cost of capital for an individual company.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 8

Consider, for example,

How do you know what it will cost to raise an additional dollar of new debt? You may seek

the advice of an investment banker. You may look at recent offerings of debt with similar risk

as yours. But until you issue your debt, you will not know for sure.

The cost of preferred equity looks easy. But how do you know, for a given dividend rate,

what the price of the preferred stock will be? Again, you can seek advice or look at similar

risk issues. But until you issue your preferred stock, you will not know for sure.

The cost of common equity is more perplexing. There are problems associated with both the

DVM and the CAPM.

In the case of the DVM: what if dividends are not constant? What if there are no current

dividends? And the expected growth rate of dividends is merely an estimate of the future.

In the case of the CAPM, what is the expected risk-free rate of interest into the future? What

is the expected return on the market into the future? What is the expected sensitivity of a

particular's asset's returns to that of the market's return? To answer many of these

questions, we may derive estimates from looking at historical data. But this can be

hazardous.

Estimating the cost of capital requires a good deal of judgment. It requires an understanding of the

current risk and return associated with the company and its securities, as well as of the company's

and securities' risk and return in the future.

If you are able to derive estimates of the costs of each of the sources of capital, you then need to

determine the proportions in which the company will raise capital. If your company is content with its

current capital structure and you expect to raise capital according to the proportions already in place,

your job is simpler. In this case, the proportions can be determined by estimating the market value of

existing capital and calculating the weights.

On the other hand, if your company raises capital in proportions other than its current capital

structure, there is a problem of estimating how this change in capital structure affects the costs of

the components. Consider a company that has a current

capital structure, in market value terms, of 50 percent

debt and 50 percent common stock. What happens to

the market value of each component if the company

undergoes a large expansion and raises new funds solely

from debt? This increase in debt may increase the cost

of debt and the cost of common stock. This will occur if

this additional debt is viewed as significantly increasing

the financial risk of the company -- the chance that the

company may encounter financial problems -- thereby

increasing the cost of capital. But this increase in the

use of debt may also decrease the cost of capital. This

could result because the company will be using more of

the lower cost capital -- debt.

Exhibit 3: Costs of capital for different

industries, 2005

Industry Cost of

capital

Advertising 9.03%

Air Transport 8.40%

Beverage 5.83%

Biotechnology 10.28%

E-commerce 18.14%

Internet 16.65%

Petroleum 6.64%

Retail store 8.16%

Trucking 6.84%

Wireless networking 13.58%

Source: Aswath Damadoran,

Whether the cost of financial risk outweighs the benefit

from the tax deductibility of interest is not clear -- and

cannot be reasonably forecasted.

http://pages.stern.nyu.edu/~adamodar/

Estimates of the cost of capital require a great deal of information on individual companies, as well as

forecasts of the return on a risk-free asset and on the market. Estimates of costs of capital for

several different industries for 2005 are shown in Exhibit 2. As you can see, these costs of capital

reflect the business and financial risk of companies; for example, the wireless networking industry

has a great deal of business risk and companies in this industry experience higher costs of capital.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 9

5. Summary

The cost of capital is the marginal cost of raising additional funds. This cost is important in our

investment decision making because we ultimately want to compare the cost of funds with the

benefits from investing these funds. The cost of capital is determined in three steps: (1) determine

what proportions of each source of capital we intend to use; (2) calculate the cost of each source of

capital, and (3) put the cost and the proportions together to determine the weighted average cost of

capital.

The required rate of return on debt is the yield demanded by investors to compensate them for the

time value of money and the risk they bear in lending their money. The cost of debt to the company

differs from this required rate of return due to flotation costs and the tax benefit from the

deductibility of interest expense. The required rate of return on preferred stock is the yield

demanded by investors and differs from the company's cost of preferred equity because of the costs

of issuing additional shares (the flotation costs).

The cost pf common equity is more difficult to estimate than the cost of debt or preferred stock

because of the nature of the return on stock: Dividends are not guaranteed nor fixed in amount, and

part of the return is from the change in the value of the stock. The dividend valuation model and the

capital asset pricing model are two methods commonly used to estimate the required rate of return

on common equity. The DVM deals with the expected dividend yield and is based on an assumption

that dividends grow at some constant rate into the future. The CAPM assumes that investors hold

diversified portfolios, so they require compensation for the time value of money and the market risk

they bear by owning the stock.

The proportion of each source of capital that we use in calculating the cost of capital is based on

what proportions we expect the company to raise new capital. If the company already has a capital

structure -- a mix of debt and equity it feels appropriate -- then that same proportion of each source

of capital, in market value terms, is a good estimate of the proportions of new capital.

The cost of capital is the cost of raising new capital. The weighted average cost of capital is the cost

of all new capital for a given level of financing. The cost of capital is a marginal cost -- the cost of an

additional dollar of new capital at a given level of financing.

In determining the optimal amount to spend on investments, the relevant cost is the marginal cost,

since we are interested in investing until the marginal cost of the funds is equal to the marginal

benefit from our investment. The point where marginal cost = marginal benefit results in the optimal

capital budget.

The actual estimation of the cost of capital for a company requires a bit of educated guesswork, and

lots of reasonable assumptions. Using readily available financial data, we can, at least, arrive at a

good enough estimate of the cost of capital.

The Cost of Capital, a reading prepared by Pamela Peterson Drake 10

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